Boards of directors in new ventures
Dan R. Dalton and Catherine M. Daily
The appropriate roles and responsibilities of boards of directors and their influence on cor porate financial performance have been subject to extensive empirical examination and discus sion for many years. In fact, many elements of the Sarbanes Oxley Act and guidelines en acted by the Securities and Exchange Commission (SEC), the New York Stock Exchange (NYSE), American Stock Exchange (AME), and Nasdaq focus on these issues.
The overwhelming majority of that body of work, however, has been focused on large scale, traditional organizations (e.g., Fortune 500, S&P 500 firms). Smaller firms have received far less attention, and new ventures even less (for a notable exception, see Daily et al., 2002). In subsequent sections, we describe a few key concepts and suggest some potentially interesting aspects of boards of directors that have special application to new ventures.
Any discussion of boards of directors would certainly include the notion of independence. The issue here is the extent to which a board can, or will, provide a dispassionate assessment of the CEO. Many observers of corporate boards of directors in new ventures 15 governance would argue that a board comprised of inside directors (officers of the firm) and affiliated directors (non employee directors who have close personal or professional relation ships with the firm or its executives) may have a tendency to support the CEO somewhat more unconditionally than a board comprised of out side directors (directors without those relation ships with the firm or its executives).
Another aspect of board independence is whether the CEO concurrently serves as board chairperson. The potential problem is straight forward: Can a board effectively monitor the CEO when the chairperson of the board is the CEO? Imagine also the extreme scenario: a board comprised of a preponderance of inside and affiliated board members with its CEO serving as board chairperson. There is a long standing view, often referred to as agency theory, that the lack of independence in the governance structures of companies will be reflected in poor financial performance for the firm. This is based on the central principle of agency theory: high ranking corporate officers, acting as the agents of shareholders, can pursue courses of action inconsistent with the interests of owners (for a review of agency theory and corporate governance, see Shleifer and Vishny, 1997). In the following sections, then, when we mention independence, it is these dimensions regarding the composition of the board and the CEO/ board chairperson issue to which we refer.
Board independence is an important element in the perception of the quality of a firm’s governance. This issue, however, can be exacerbated for new ventures because the CEOs are often the founders. For the new venture, then, it is possible that (1) the founder is the CEO; (2) the founder is also the board chairperson; and (3) the board is not independent. Importantly, the perceived lack of independent governance in a new venture can adversely affect its relationship with external constituencies – constituencies that may be critical for the new venture’s growth and success.
Consider, for example, the venture capital community. Many venture firms will seek the support of venture capitalists (VCs). Obviously, VCs are a source of funds, but it is also true that the survival rates of venture backed firms are much higher than for firms without VC funding. VC firms, however, are extremely selective in choosing which firms to support. Among the factors that VCs will carefully evaluate are the overall governance of the firm, the nature of its board, and whether the founder is CEO. In fact, VC firms will often ‘‘nominate’’ board members to be added to the firm, often insisting that they have representation on the boards in which they invest.
An initial public offering (IPO) is another means of raising funds for new ventures’ growth and development. This process, too, will be informed by the governance structures of the firm. While the IPO process, managed by an investment bank (IB) is complex (for an overview of the IPO process, see Certo, Daily, and Dalton, 2002; Ritter, 1998), a critical step is setting the price at which the IPO firm’s stock will be offered to the public. Board independence, given the value placed on independent governance structures by key shareholder groups such as institutional investors, may serve as a proxy for firm quality, enabling the IB and the firm’s owners to extract a higher value when setting the opening price. This is, of course, in the interests of the new venture firm that is going public.
Interestingly, there is also a synergistic effect of VC involvement in the IPO process. VC participation in a new venture can serve as a powerful signal to potential investors about the quality of the firm going public (e.g., Megginson and Weiss, 1991) and this, in turn, is related to more capital raised through the IPO process for the firm’s treasury.
Equity holdings by the members of the board is another factor that may affect the new venture leaders’ ability to raise funds, particularly in the IPO context. Agency theory suggests that when outside board members hold substantial equity positions in the firms they serve, they are more likely to act in shareholders’ interests (for a discussion of equity holding by board members, see Dalton et al., 2003). Individuals and institutions that might purchase stock in an IPO company would be much more comfortable knowing that the board’s interests and theirs are similar (i.e., all are shareholders in the firm).
The size of the board of directors may also be of interest to those considering an investment in the new enterprise (for a discussion of board size and financial performance, see Dalton et al., 16 boards of directors in new ventures 1999). Specifically, larger boards may signal that the firm has access to a wider range and quality of critical resources: information, people, capital, raw materials, services (for a comprehensive discussion of ‘‘resource dependence,’’ see Pfef fer and Salancik, 1978). This perspective is also consistent with ‘‘social capital’’ theory, the notion that social networks (e.g., the people you know and to whom you have access) can increase the venture’s overall resources as well as effectively leverage its current resources (e.g., Florin, Lubatkin, and Schulze, 2003). It has been demonstrated that board size is related to the financial performance of the firm; notably, that relationship is even larger in the case of smaller firms (Dalton et al., 1999). It is also interesting that larger boards are associated with greater net returns for IPO firms (Certo, Daily, and Dalton, 2002).
In fairness, board networking can be a mixed blessing. An obvious means to secure high qual ity comparative information about best practices, for example, is when board members serve on multiple boards. The number of directorships held by directors, however, has been subject to sharp criticism by the business/financial press and shareholder activists. Their point is that, beyond some threshold (e.g., member ships in more than three or four boards), additional directorships compromise directors’ attendance, attention, and effectiveness.
The current environment of corporate governance appreciably shapes both the mature company as well as the new venture, but at different stages. The governance structures of large scale, publicly traded corporations have never been under the current level of scrutiny. Interestingly, the new venture is unlikely to grow, develop, and become a public company without focused attention on its governance structures as well.
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Who cares about governance structures in new ventures? |
Issues that may be of concern |
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Venture capital firms |
Independence of the board of directors |
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Investment banks IPO investors |
Same person serving as CEO and chairperson of the board |
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Securities and Exchange Commission |
Founder of the firm as CEO and/or chairperson of the board |
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Stock exchanges |
Extent of equity holdings in the firm by board members Size of the
board of directors |
Bibliography
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Dalton, D. R., Daily, C. M., Johnson, J. L., and Ellstrand, A. E. (1999). Number of directors on the board and financial performance: A meta-analysis. Academy of Management Journal, 42: 674 86.
Florin, J., Lubatkin, M., and Schulze, W. (2003). A social capital model of high-growth ventures. Academy of Management Journal, 46: 374 84.
Megginson, W. L. and Weiss, K. A. (1991). Venture capitalist certification in initial public offerings. Journal of Finance, 46: 879 903.
Pfeffer, J. and Salancik, G. R. (1978). The External Control of Organizations: A Resource Dependence Perspective. New York: Harper and Row.
Ritter, J. R. (1998). Initial public offerings. Contemporary Finance Digest, 2: 5 30.
Shleifer, A. and Vishny, R. W. (1997). A survey of corporate governance. Journal of Finance, 52: 737 83.